8 minute read
Chain reaction
The potential for blockchain technologies to disrupt the financial services industry is growing, but businesses should not rush in blindly
BY SEBASTIAN RATH
The digitally-connected consumer age for financial services is here and accelerating fast. Global consumption is increasingly digitally empowered. This trend determines which financial services succeed and grow, which ones specialise, and which ones might not connect with future customers.
Digital ecosystems are success factors enabling financial services firms to thrive, to deliver superior customer-centric experiences, and to respond to increasing demand for instant analytical information. Globally, this is evident in trends for deeper business intelligence, the use of data mining, big data, and data analytics.
These developments are not entirely new, but emphasis on data infrastructures has gained significant momentum with blockchain technologies entering the mainstream. In summer 2016, the World Economic Forum said that blockchain would “become the beating heart of the global financial system.” The technology promises to create an ecosystem of banks, insurers, capital market makers, brokers, governments, asset managers and pension providers that can deliver seamless customer service. But what is blockchain and why does it matter?
Unique characteristics
The origins of blockchain arose with Bitcoin, which was a response by cryptographers to systemic trust-issues
emerging from the last financial crisis. In simple terms, blockchain is just another distributed database. It comprises a list of ordered records called blocks. Each block contains a timestamp and a link to a previous block. That structure gives it five unique characteristics.
First, users write to the blockchain, but cannot delete individual blocks, which means that blockchain preserves transactional records, without deleting them. Second, unlike traditional central-ledger databases, blockchains use multiple, decentralised instances that are all-time fully synchronised. This means that users can work on multiple instances of your blockchain across the globe. While this makes the database more power hungry, it provides redundancy and data security.
Third, blockchains can automatically interact with your core data. So-called smart contract and side chains are codes that allow for effective, instant and cost-effective selfexecution and self-validation of data and transactions. For example, they can facilitate payments and contractual arrangements as soon as defined conditions are met. Such automation is an inherent benefit of blockchains for customers of financial services, facilitating faster, data-driven and cost effective transactions.
Fourth blockchain’s privacy can be tailored. Bitcoin introduced the concept of a public blockchain, where data is transparent and visible to anyone with access to the global public Bitcoin blockchain. But it does not have to be that way and private and semi-private blockchains require managed access and usage restrictions.
Finally, saving data to a blockchain creates data blocks that are cryptographically safe. In simple terms, hashing produces data blocks, together with a string of information uniquely summarising the block’s content. Blocks are then connected to blockchains using these information strings as explicit, unique references to their prior and following blocks. This ensures that attempts to modify the block’s content automatically invalidates the referencing across the chain, which fundamentally strengthens blockchain’s data integrity from its beginning – the so-called genesis-block.
Big business
The funding of 92 blockchain and bitcoin startups attracted US$429m in the first nine months of 2016. Projected spend on blockchain projects for 2017 exceeds US$1bn. Banks lead in these developments, but insurers are also active. For example, the French group AXA, with its internal capital venture fund AXA Strategic Ventures made one of the largest commitments in 2016 when it acquired Blockstream. The Canadian company specialises in developing smart contracts.
Aimed at consumers, insurance startup Trov launched on-demand insurance for short and bespoke time-periods, at the click of an app, greatly leveraging the transactional simplicity of registering live contractupdates on the blockchain. During 2016, the InsurTech sector concluded that blockchain ecosystems support product innovation across the claims process, travel insurance, rental car insurance, pay-as-you-stay, home insurance, crop insurance, health insurance and patient record management. Further insurance product segments may come into focus as connected devices and the integration of the internet-of-things develop. The World Economic Forum’s report The future of financial infrastructure provides a detailed segmental analysis of the opportunities in these areas.
High-paced risk
Blockchain ecosystems are likely to see a high-pace of development over the next few years. The key risks for blockchain is in the IT risk domain, which can be managed in a similar way to developing ecosystems in the open source domain.
Forums have established analysing and discussing incidents and technology issues in the use of digital assets, digital risk transfers and the use of blockchains in financial services. The uses of smart contracts for financial services are particularly likely to advance quickly, driven by global consortiums and blockchain providers.
Financial services firms are likely to marry some of their existing challenges with the potential of blockchain. Four areas are likely to advance considerably in 2017 include:
• Automating financial risk transfers
Applications will develop across financial and risk trading, hedging, distribution, brokerage and intermediation. Those will leverage costs, speed or operational efficiency gains. Likewise, product solutions will be blockchain-enabled. Applications across payments and claims management provide benefits for customers and firms. Businesses and their supply-chain management will be active in increasing transparency for more effective risk transfers. Some initiatives will focus on establishing deeper trust, others on connecting with new customer groups.
• Market issues, fraud and trust
Since firms compete, areas for data sharing are sensitive and limited.
Such competitive limitations reduce in areas where overcoming joint hurdles is important. For example, blockchain initiatives tackling fraud risk or financial abuse will credibly leverage trust and support complex, timely needs for information across participants. Such initiatives promise to credibly reduce potentially unfair costs to customers.
• Managing climate change risks
For businesses, corporates and financial markets, timely access to global climate information is becoming more important. Blockchain’s decentralised systems can uniquely service such needs both locally and globally. Providing immutable ledgers with permissioned smartcontracts, blockchains can enable more automated verification techniques and the use of climate statistics, leading to more dynamic data interpretation. This should facilitate actionable insights and provide the potential to deliver key indicators informing supply chains and future financial risk transfers.
• Digital government, social and health services
Financial services will interact with those sectors requiring frequent data exchanges, while facing huge potential for reducing complexities, replacing aging ledger systems and exchanging sensitive information.
The UK is exploring new ways of paying government benefits. Likewise, many firms have built new models tracking and completing digital heath-records, ensuring better interoperability across health services, pharmaceutical and health technology providers.
Operational key risks include scenarios of instability, impairment, disruption, maintenance, updating, future proofing and cost-control. Regulatory risks still remain largely undefined, while selected and initial views start to shape. This is often compensated by a consultative approach by leading global financial regulators, seeking discussions with industry. Likewise, legal and compliance risks for blockchain ecosystems are not mature. Together, these effects could result in reputational and financial risks, if not appropriately mitigated.
Organisations looking to adopt blockchains would do well to follow some basic steps. To get started, they should assess the skills, training needs, and organisational readiness for sandbox deployments – those that are conducted under controlled circumstances. There must be a clear reason for using the technology and the inherent value for blockchain transactions should be calculated.
Across counterparties, businesses need to establish requirements, individual expectations for leveraging blockchain benefits, a joint view for the operating model, and estimates on transaction data volumes and frequencies. They should choose a blockchain provider with clear requirements on operational, IT maintenance, costings, and inherent risks. Finally, for the overall project, establish a blockchain roadmap, with shared views on timelines, feasibility, testing, rollout, regulatory interaction and external partnerships.
Challenges
Businesses should try not to get carried away about disrupting the industry, or the buzz around blockchain technology. What matters is making a solid start. Initially, getting to a sufficiently broad understanding of blockchain across relevant parts of the firm is key because without it, it could be difficult to get buy-in. Reaching a sound commitment to fund blockchain projects can be a long journey, depending on a firm’s opportunistic agility to exploit new technologies. The industry may be fast moving, but the business may need to go at its own pace.
Typically a process of thoughtgeneration requires several iterations by dedicated teams. At early stages, potential requirements may change frequently – and the teams should be ready for this. Eventually, this leads to a maturing organisational readiness to work with external blockchain providers. Strong leadership and vision are required, together with a collaborative approach, a culture of effective innovation with focus on actions and goal-oriented outcomes. Finally, a sound grasp on the choices made helps the team to steer the project effectively given the fast-developing nature of blockchain ecosystems.
Blockchain does pose a threat to businesses that do not adapt quickly enough. But that does not mean that organisations should rush in without following careful analysis and testing programmes. Risk managers have a critical role to play in assessing both the internal and external risk factors that blockchain creates. Beyond the hype, there are likely to be real benefits for those who proceed with care.
